By David Nelson, CFA
For the bulls it was one of the worst weeks in a decade on the heels of a quarter and month bad enough to have market historians scrambling for comparisons. The Financial Crisis, the crash of 1987, the breakout of World War II and of course the Great Depression all come to mind.
You can bet that in the moment investors then believed there was no path forward and capital markets would never recover. Last week was almost a perfect storm as a series of events collided forcing investors to the sidelines in chaotic back to back market declines.
Policy Mistake
While some economists and strategists defended last week’s decision by the Federal Reserve to hike interest rates another 25 basis points you won’t find me among them. This was a policy mistake followed by a press conference that did little to explain their mindset. Chair Powell and the FOMC appear to be running on auto pilot oblivious to some of the red flags that are screaming for them to take control of the aircraft. During the press conference Mr. Powell admitted they’ve seen a slowing of growth around the world and that financial conditions have tightened, so it begs the question why not pause and let the last few hikes wash through the system before moving forward.
The United States doesn’t live in a vacuum and Fed actions have a ripple effect that touches almost every corner of the planet. Markets are a pretty powerful leading indicator. With the exception of Brazil and India nearly every market in the world is deep in the red. Ultimately, these countries are our customers and eventually hits the top and bottom line of U.S. multi-nationals.
WTI Crude 1 Year
One half of the Fed’s dual mandate is inflation. With oil down near 40% and inflation to date well contained it again begs the question, why the urgency? Energy touches everything in the cost chain acting as a deflationary force. With oil below $46 a lot of U.S. energy producers will find it difficult to remain profitable an issue that isn’t lost in the high yield credit markets.
Fed Gets the Memo
The good news is it looks like the Fed got the memo. On Friday NY Fed President in a CNBC interview emphasized that “officials are listening carefully to markets.” While the Euphoria didn’t last long the comment immediately sent stocks up over 1% in just a few minutes. The rally fizzled quickly and by the close of day the S&P sat at levels not seen since June 2017.
The Fed’s Wall of Worry
The Fed’s Wall of Worry is a balance which at its peak had grown to $4.5 Trillion on the heels of Quantitative Easing. In October 2017 they started the process of ending the replacement of securities that matured, effectively reducing the balance sheet over time. They continue to tweak the program but for the moment seem to be letting $50 Billion run off each month and reinvesting the rest. At this pace it will take about 6 years to reach pre-crisis levels.
No question normalization is the only path forward but if you want the patient to survive the operation be prepared to make some adjustments along the way. The first mistake was not starting the process sooner and the second is an Obama era mindset that the United States can’t sustain anything more than a 2% GDP. The hot employment numbers and strong GDP reports earlier this year seemed to give the Fed a green light to slam on the breaks with a matching rhetoric that forced investors to the sidelines.
The truth is, this is the end of an experiment. We have nothing in history to act as a guide. Maybe it will have to be more than 6 years and who knows if economies around the world recover quickly a faster pace may be warranted. The Fed desperately wants to get to neutral and judging by their statements, 2.8% or about 2 hikes from now seems to be the target. They need the wiggle room to take accommodative action to ward off the next recession. However, moving forward on auto-pilot just might cause what they are trying to prevent.
The Bottom
Bottoms are only visible in the rear view mirror but we can at least go through the exercise of trying to determine worst case scenarios. We’ve broken key support levels and there’s always another one to look to but let’s put the technical charts away and focus more on fundamentals. In the end most bear markets bottom when value players step in willing to stand in front of the train because valuations and or dividends demand it.
Let’s take a valuation walk down memory lane. The chart above plots S&P 500 price performance from the start of the dot.com bubble to the present. Superimposed in pink are trailing 12 month Price/Earnings or P/E ratios. One could make the case right now that we’ve hit a good area of valuation support especially considering even today the risk free rate is still quite low. Current trailing PE for the market comes in just under 16x and matches levels we saw several times in the last 5 years. However, better support comes in at lower levels.
Nothing in life is certain but I believe a trailing PE of 13 would force value players out of the bunker focused on stocks with high free cash flow yields and growing dividends. Yes, it’s true that valuations hit lower levels during the financial crisis but I view that as a one off event with few of the same dynamics in place.
One thing that stands out in this chart is that the bull market starting off the lows of 2002 took place in an era of multiple contraction. The trailing PE was headed South while markets and earnings were on I-95 North. In other words earnings were rising faster than valuations. The bull market run following the financial crisis showed markets and valuations were expanding at the same pace a less healthy environment, largely on the backs of mega-cap growth stocks like AMZN, GOOGL and others with well above market valuations.
13x trailing 12 month earnings of $161 would bring the S&P 500 down to 2093. That’s within 2% of the closing level for Election Day 2016 and the beginning of the Trump bump. And as fortunes would have it strong technical support as well. Unfortunately, that’s about 13% lower and a complete unwind of 2 years of price performance.
Before we start jumping off buildings let’s be clear. This isn’t a prediction but a potential worst case scenario that we have to at least explore.
Many will point to trade, tariffs and a dysfunctional Washington at the heart of investor concern. While admittedly these are the usual suspects I still believe the Elephant in the Room is the Federal Reserve and quantitative tightening. In hindsight I think most would agree that QE was responsible for some portion of the Bull Run in the last decade. It’s only logical that QT (Quantitative Tightening) will make the path forward a little more difficult.
Like I said earlier, market bottoms are usually only visible in the rear view mirror but if history is any guide it’s only after we’ve been through the 5 Stages of Grief usually reserved for those with a terminal illness that we can safely say the bottom is in.
- Denial
- Anger
- Bargaining
- Depression
- Acceptance
Each of us has our own threshold for pain but I think we can safely say that most of us have reached Stage 2.
